A passive investment strategy seeks to track the performance of an index by mimicking its holdings. Primarily because of their low-cost structure, well-managed index investments such as an index-based mutual fund or ETFs have generally outperformed higher-cost investments over the long term. When advisers index a solid portion of their clients’ portfolios, their clients often benefit from lower costs, broader diversification and minimal cash drag. These elements can translate to a long-term performance edge.

Zero-sum game

Understanding the zero-sum game

As a group, market participants are playing a zero-sum game. That is, half of investor assets outperform and the other half underperform the market average. The bell curve in Figure 1 illustrates this, with the market return shown as a dotted line. In reality, however, investors pay commissions, management fees, bid-ask spreads, administrative costs and, where applicable, taxes, all of which combine to reduce realised returns over time. These costs shift the curve to the left. A portion of the after-cost asset-weighted performance continues to lie to the right of the market return, represented by the tan region in Figure 1. But a much larger portion is now to the left of the dotted line, meaning that, after costs, most of the asset-weighted performance falls short of the aggregate market return. Given the difficulty of selecting an active manager who consistently outperforms the market, we believe many investors are better off using a passive approach, minimising costs so that, over time, they can achieve a return close to the market average.

The zero-sum principle holds regardless of a market’s efficiency. Even in areas traditionally considered inefficient, such as emerging or small-capitalisation markets, our research has shown that most active managers fail to outperform their corresponding benchmarks.

Figure 1: Investing is a zero-sum game

Half of all invested assets will outperform the market return before costs (blue curve). After costs (brown curve), a much smaller portion outperforms the market return (tan).

Source: Vanguard

Indexing cost advantage

The indexing cost advantage

The role of costs is so critical to investment success that it merits a closer look. The return from a mutual fund or ETF reflects the returns of its underlying holdings less transaction costs and expenses charged by the fund.

Compared with index funds and ETFs, active funds typically have higher expense ratios. As at 31 December 2012, investors in actively managed Asia ex-Japan equity funds were paying an average annual expense ratio of 1.77%, and those in actively managed global equity funds were paying 1.58% annually, versus 0.55% and 0.46% for the corresponding index-based ETFs.1

While the expense ratio is easy to measure, many other fees are harder to estimate. Turnover, or the trading within a fund, results in transaction costs including commissions, bid-ask spreads, market impact2 and opportunity cost. These costs are incurred by every fund and detract from net returns, but they are difficult to measure. Active funds often have higher transaction costs, due to the generally higher turnover associated with active management’s attempt to outperform the market.

1 Source: Vanguard analysis, based on data obtained from Morningstar on 17 June 2013.

2 In this context, market impact refers to the effect of a market participant’s actions – that is, buying or selling – on a stock’s price.

Difficulty of active management

Active managers frequently underperform

Even before accounting for merged or closed funds, actively managed equity funds, on average, have fared poorly versus their benchmarks over the past decade.

Figure 2 compares the performance of actively managed funds in various fund styles to the performance of an appropriate style benchmark. For the ten-year period ending 31 December 2012, the relative underperformance of actively managed funds versus their style benchmarks has been consistent across and within asset classes. Comparisons over three- and five-year periods yield similar results.

Consistently picking winning managers is difficult

Even for managers who outperform the market in a given year, success can be fleeting. Figure 3 shows the relationship between the past and future performance of top-quintile actively managed funds, as measured over two discrete five-year periods. The data shows that only 11.2% of the top-quintile funds from the first five-year period remained in the top-quintile over the next five years. In addition, investors who selected a top quintile fund from the first five-year period stood a 61.5% chance of seeing that fund fall into the bottom 40% of funds or of seeing the fund disappear altogether over the subsequent five-year period.

The essentially random nature of active returns over time helps to explain why investors who change managers in search of market outperformance are often disappointed.

Figure 3: The relationship between past and future performance is nearly random

Notes: Actively managed funds were divided into quintiles based on their excess returns relative to their stated benchmarks during the 5-year period ending 31 December 2007. These funds were then followed in the subsequent 5-year period ending 31 December 2012 to determine their relative performance.

Source: Vanguard analysis, based on data from Morningstar, Inc.

Other indexing benefits

Other benefits of including indexing in client portfolios

In addition to the potential performance edge that indexing offers relative to higher cost investments, index funds and ETFs have other traits that make them appealing to investors.

Diversification. Index funds and ETFs typically are more diversified than actively managed funds. Except for index funds that track narrow market segments, most index funds must hold a broad range of securities to accurately track their target benchmarks. The broad range of securities lessens the risk associated with specific securities and removes a component of return volatility.

Style consistency. An investor who desires exposure to a particular market and selects an index fund that tracks that market is assured of a consistent allocation. An active manager may have a broader mandate, causing the fund to be a moving target from a style point of view. Even if a manager has a well-defined mandate, the decision to hold a higher or lower proportion of a security than the index holds will lead to performance differences.

Transparency. Because they are designed to track an index and hold the same securities (or a representative sample), index funds and ETFs are transparent and easy to understand.

Combining indexing with active management

Investors who seek market outperformance, but without the potentially higher costs and risks of an all active portfolio, may benefit from a combination active-passive approach.

One such approach is a “core-satellite” strategy that employs indexing at the core of a portfolio and actively managed funds as satellites. The indexed core provides a risk-controlled, low-cost way to capture market returns (beta), while the actively managed satellites provide an opportunity for market outperformance (alpha).

To learn more about the benefits of including indexing in your clients’ portfolios, contact your Vanguard sales representative.

Research Paper

Vanguard Investments Singapore Pte. Ltd. (“VIS”), registration number 200303953E, is regulated in Singapore by the Monetary Authority of Singapore. VIS holds a Capital Markets Services licence and operates as an Exempt Financial Adviser under Singapore law.

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